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Recent activity in the MLP energy infrastructure space is showing a lessening of the correlation between MLPs and the price of oil.   This correlation with oil created a dramatic drop in the Alerian MLP index, from August of 2014 into the middle of February this year, when the prevailing thinking on Wall Street was that MLPs were a surrogate for oil.

What has changed is that investors are starting to realize that MLPs are more than just about the price of oil.  They are beginning to recognize that these are operating business involved in the ongoing and necessary transportation, distribution, fractionation, and storage of natural gas, natural gas liquids, and oil.  Cheap oil only increases the use of oil.  As one of my baby boomer clients noted, RV sales are going through the roof as baby boomers set across the country in their gas guzzling Winnebagos because gas is cheap.  That means it would only be natural to process and transport more refined products, not less.

In addition to that, the use of natural gas is rising as a fuel for electrical generation.   Natural gas is rapidly replacing coal and nuclear, as exports to Mexico continually increase, and LNG exports build to Europe and Asia.  Coming up is a dramatic increase in the use of ethane as billion dollar petrochemical plants get built and placed into service in the Southeast, Northeast near Pittsburgh, and all the way up in Ontario, Canada. Business is looking better for MLPs.

 

-Dave

MLP earnings season has been very positive for the vast majority of companies. Volumes across many pipeline systems held up better than many observers expected. The rig count has increased for 7 straight weeks as producers are starting to drill again. Many of these rigs have been placed in the Permian Basin in Texas, as it’s very profitable in this basin for many producers at the current oil prices. The MLPs that operate in the Permian also fared well during earnings calls. On the natural gas side, the Marcellus and Utica shales also showed strong volume growth for several of the companies we are invested in. The recovery in natural gas liquids (NGLs) prices was discussed by many MLP management teams and they believe NGL pipelines will see strong volume growth and increased earnings over the next several years. Much of the NGL recovery will be driven by increased ethane pricing due to numerous petrochemical facilities coming on-line that will significantly increase demand for ethane.

 

Another notable development is that several MLPs have entered into joint ventures on major pipeline projects. This helps fund other projects and also improve the balance sheet, which the market has viewed as favorable. Another benefit of joint ventures is that it helps prevent overbuild in certain shale plays as other projects are cancelled. The largest deal occurred when Sunoco Logistics and Energy Transfer sold a 36.75% stake in their Bakken pipeline for $2B. This move repaired balance sheets and a competing pipeline was cancelled as a result of the deal. All in all, we view this earnings season as very positive.

DeWitt Capital focuses on MLPs that benefit from the increased production and use of natural gas (methane). This weekend over 200 million Americans will experience temperatures over 90 degrees.  This means electrical generatation will have to rise to meet the need for air conditioning.  Natural gas is the one fuel that represents a path forward that is both readily available and reduces carbon emissions versus the other readily available resource, coal.

Exports of natural gas to Mexico is are growing quickly, tripling  over the last three years with expectations of doubling over the next two years.  Liquified natural gas is beginning to ramp up as import facilities have been converted  to export facilities!

Although MLP stocks prices have largely traded in line with oil over the last twenty four months, that correlation is beginning to break down. We have noticed lately that MLP prices are starting to chart their own path. Natural  gas and natural gas liquids (ethane and propane) are seeing a resurgence in both demand and pricing.  DeWitt continually researches the energy infrastructure universe to discover those companies that benefit from these trends. Eventually the market will reward the increasing cash flow generated by these companies while investors enjoy the ample distributions they provide.

When I read and hear people complaining about getting a miserable 2 percent on their money and struggling to find a livable cash return on their income portfolio, I wonder why they don’t add Master Limited Partnerships that are yielding on average 8 percent. Here is the good and the bad:

First the good: as I just stated, the average yield is about 8 percent and the dividends on most MLPs have risen every year for the last three decades. Not only is it rising, but the dividend is about 80 percent tax sheltered on average, varying for the different MLPs. The investment is in America’s energy infrastructure so it has no foreign competition. The business is composed of hundreds of thousands of miles of pipelines, along with storage facilities, processors, and other related businesses. It is an investment in the management of the fuel that runs America. It provides reliable steady income and this should be no surprise.

Now the bad news: Today the prices of MLPs have been wildly volatile. The whole sector has traded as if it were a biotech stock. It all depended on the price of oil. And over the last year, some actually eliminated their dividends and some went bankrupt. And those MLPs gave the whole sector a huge black eye.  In 1991, MLPs were businesses engaged in the transportation business (pipelines.) Today, there are MLPs that drill for oil and dig up sand for fracking. The oil drillers have gone bankrupt and investors lost almost all of their money.

DeWitt Capital Management invests in the companies that manage the throughput. So whether the price of oil was up or down, we still had to move oil and gas and get it to the consumer. Did you stop driving your car when oil was cheap? Did jets stop flying? Did the 18-wheeler pull off the road? No, there is still energy demand and so the MLPs managing the throughput keep paying out dividends.

An MLP portfolio can be designed for people at various stages of life. Pre-retirement, post retirement, and later retirement portfolios can be crafted for every need at every stage of life.  Someone who is still working but looking for more capital appreciation could invest in a professionally selected portfolio of MLPs that could potentially raise their distributions quickly and thereby drive the price of those MLPs quickly. By the time the investor reaches retirement age, the portfolio should be paying out rising income at a higher level.

An investor who has recently retired and who is invested in a portfolio of low yielding municipal bonds or government bonds and stocks, could switch part of their portfolio to higher yielding MLPs that have the ability to raise distributions over time.  Because of the tax deferred nature of those distributions, their tax could be lowered while at the same time, have spendable income increased.

Someone further on in life may want to spend more time with the grandkids and family members at a vacation home or engage in travel.  However, the yields on government bonds and municipals being as low as they are could cause some discomfort.  The solution:  Invest in a portfolio of high yielding and conservative MLPs that provide high income with most of the income tax sheltered.  The retiree can enjoy years of tax sheltered income, enjoying time with their friends, family and grandchildren.  When the client passes these MLPs onto their children, the deferred tax bill is eliminated.

After 25 years of investing and tracking Master Limited Partnerships, DeWitt Capital knows the MLP world inside and out.  We can build an MLP portfolio to suit each individual at every stage of life.  See what you and your clients are missing by not investing in America’s energy infrastructure!

The business of America’s energy infrastructure is not subject to competitive threats from overseas and will not be outsourced to China! It is everywhere around you, operated by Americans, and keeps America moving.  This sector belongs in everyone’s portfolio.

New investors reviewing the recent performance of MLPs might be scared off for good. But the reality is that market volatility is not quite what it seems, because MLPs have maintained or boosted distributions despite a collapse in oil prices. According to a Think Advisor interview with Jeremy Held, director of Research & Investment Strategy for ALPS Portfolio Solutions, to the patient go the spoils.

“Long-term investors, if can they can withstand the volatility … will be rewarded for staying the course in the asset class,” Held explained.

What new investors need to look for in MLPs
The most important thing to keep in mind for new investors looking into the MLP space for the first time is that fundamentals matter more than oil commodity price volatility. In the long term, the fundamentals for MLPs, particularly midstream companies, will remain intact because demand for oil will continue to be prevalent. So too will the growing need for energy infrastructure.

This is the reason why midstream MLPs have withstood oil price drops in the last two years. For instance, oil prices ranged from $92 to $117 a barrel and distributions increased by 7.3 percent in 2013, while oil prices dropped to between $59 to $106 per barrel and distributions improved by 6.8 percent in 2014. This has been further evidenced in the last 12 months as oil has dipped to about $43 to $60 a barrel, but distributions have increased by 7.5 percent. In fact, midstream distributions have increased by 1.9 percent in Q2 2015, up from 1.5 percent Q1.

Therefore, new investor concerns about declining oil commodity prices need to be put into context. What matters most is the stability of the distribution, something midstream MLPs have maintained in all market conditions.

MLPs as a hedge for savvy investors
MLPs offer investors real assets that act as a great hedge against inflation and market conditions. This is due to the fact that most midstream MLPs have long-term contracts that are indexed for inflation. In fact, MLPs operating pipelines were allowed to raise their fees 4.58 percent. In July, federally-mandated tariff increases were implemented for pipelines, which include the Producer Price Index. Therefore, with oil prices likely to stabilize with the domestic production boom combined with the increasing demand for oil, midstream MLPs are positioned for growth in the next few years.

The bottom line is distribution growth
MLPs are down by over 18 percent since January, making many lose faith in the sector. New investors see the record lows in oil prices, and may be scared off from the energy sector as a whole. But it is important to note that the Alerian MLP Index has grown by 4.3 percent this third week of August, showing that the sector has recovered a substantial portion of the losses it incurred with the price collapse.

Supporting this rebound is Darren R. Schuringa, chief investment officer for Yorkville Capital, who explained that midstream MLPs are yielding 7.5 percent. What this means is that the pullback in the sector was not related to the fundamentals of these midstream companies. So with these midstreamers unaffected by market volatility, distributions have been maintained and exceeded.

For context among new investors to the sector, the spread between MLPs and U.S. Treasuries is a good comparison. This is due to the fact that historically, when spreads between MLPs and U.S. Treasuries have been wider than 5 percent, MLPs produced positive returns over the next twelve months 100 percent of the time. This is what makes the current market conditions a great entry point for new investors.

But when infrastructure MLP distributions are put under review, it is clear that with 11.5 percent growth year-over-year, investors are provided with high yielding assets that are volatility resistant.

Oil and natural gas MLPs in the midstream sector generate returns by transporting the commodities, so they are much less affected by the price of oil. Still though, market speculators have overreacted to the decline of MLPs this year, despite their steady returns, thus putting many midstream companies to be on sale.

Comparing the performance of midstream and upstream sectors
Midstream companies are the MVPs of the MLP sector because they operate on long-term fee-based contracts that act as toll-roads. This business model enables them to not only get paid, but to make steady distributions. In turn, as midstreams are removed from oil prices, they are concerned with the volume and distance oil travels through pipelines. Oppositely though, upstream companies are not as resistant to oil commodity prices. According to a Rig Zone interview with Hinds Howard, CBRE Clarion Securities’ vice president and senior financial analyst, upstream companies have higher volatility.

“Hedges rollover and higher levels of debt catch up with cash flow,” Howard explained. “Reserve redeterminations based on lower commodity prices create more cash flow constraints. All of that leads to distribution cuts. After almost every upstream MLP cut its distribution, it will be hard for any MLP to regain the confidence of the market. So, I would say they are structurally challenged and increasingly irrelevant for MLP investors.”

Further, Howard noted that the midstream companies that experienced the oil rout have as good a chance of recovering nicely after rebounding but without the same level of risk as upstreams.

Two prime examples of midstream companies performing well are Enbridge Energy Partners LP and Plains All American Pipeline LP. Enbridge Energy Partners has underperformed in the last 12 months, as it dropped 15 percent over the previous month. Despite these dropps, though, Enbridge is still offering unitholders an 8 percent yield. Two advantages Enbridge has on the midstream market are that it can deliver both light and heavy crude through its pipelines, and it has a vast network of pipelines that afford it the opportunity to transport oil to a wide range of markets including eastern Canada, the Northeast U.S., the Midwest and the Gulf Coast. So while it is down 25 percent this year, the company generates 80 percent of its income from fee-based contracts, and the rest of its revenue is hedged with storage facilities. These factors combine to ensure steady cash flows for investors.

On the other hand, Plains All American Pipeline is down 14 percent this month, but still offers a 7.6 percent yield. One of the primary benefits Plains All American has in the midstream sector is that it transports crude oil and natural gas through its pipelines from the most productive basins in North America. Although, it also has a diversified revenue stream by storing oil and natural gas, which positions it for a competitive advantage in a market with a glut of cheap energy supplies. In turn, Plains All American benefits from volatility in oil prices because it generates revenues on the spreads between commodities prices in North America.

Cramer sees bullish markets for midstream MLPs
Mad Money’s Jim Cramer speculated recently that midstream MLPs were attractive, even as the Alerian MLP ETF Index hit four-year lows. Cramer commented that a combination of stabilized oil prices and the slowing world economy – that could force the Fed to hold off on rate hikes – have made midstream MLPs an intriguing investment opportunity now. One of the reasons for MLPs is that they offer generous returns as compared to bonds, as the average yields are 7.8 percent. Although Cramer noted that MLPs, even midstream companies, rebound strong after they drop. For instance, since the recession, midstream MLPs have provided a 40 percent return after hitting lows. So, while midstream companies are significantly undervalued, it is important to pick the right companies. Fortunately for investors, the sector has plenty to offer.

Bottom line for investors
Ultimately, investing in high-yield securities may seem to have an excess of risk attached to the assets, especially when they are in volatile markets like energy commodities. But there is no shortage of market overreactions when it comes to the midstream MLP sector. Particularly when most companies have steady cash flow and expect to continue to cover distributions in the near-term. This is why some market analysts are turning bullish on MLPs because even as upstream and midstream companies melted down, there was still plenty of value in the midstream sector. In fact, it is expected that the higher performing midstream MLPs will benefit from rate hikes, which makes the low prices they are trading at now look like bargain buys. The reason for this continued profitability of midstream companies is that as the economy gets healthier, these MLPs will transport and store higher volumes of crude oil and natural gas, thus passing down higher income to investors from their increased cash flows. This is not a benefit that bonds, with fixed coupons, can provide.

With uncertainty in the market comes market irrationality. However, bearish markets also bring out savvy investors that are looking to make gains on discrepancies in price volatility. So for those looking for high yields in a down market, midstream MLPs are the way to go.

There are five factors that make MLPs in the midstream sector particularly attractive. Their prices are not historically volatile, their performance is only minimally tied to energy prices and interest rates, and they are not overly sensitive to commodity price volatility, meaning that they will continue to provide steady income with strong growth potential in bearish markets.

This is due to the unique position of midstream MLPs with respect to correlation with long-term profits and the expected boom in U.S. oil and natural gas activity. With the immense growth in domestic shale oil and natural gas production, midstream MLPs have been blessed with a golden opportunity. As energy drilling and production grows, transportation and storage will grow with it. This is why: midstream MLPs have toll-based contracts for which they collect fees. So with long-term projects expected to boom, so too will the number of long-term contracts, positioning midstream MLPs as the center piece to meet global demand. Therefore, it does not matter whether oil trades at $40 or $140, midstream MLPs will still make money.

Therefore, it does not matter whether oil trades at $40 or $140, midstream MLPs will still make money.

MLP optimism
As many energy commodities have dipped in prices, yields for midstream MLPs have continued to climb. Although MLPs have seen their shares fall in anticipation of rate hikes and the Alerian MLP index has dropped 16 percent in 2015, the Index still yields 6.96 percent, representing an increase from 2014. Comparatively, other alternative investments such as REITs, utilities and 10-year Treasury Bonds did not stack up to MLPs, as they yielded 3.6 percent, 3.5 percent and 2.2 percent, respectively. So while the sector has slumped due to a short-term decrease in the domestic demand for oil, some investors feel that production may stall and volumes through pipelines may fall. This would of course reduce the growth rates for MLPs in the midstream sector if prices remained low for an extended period. However, despite these pressures, MLPs continue to be uniquely positioned for long-term growth potential. According to an interview with Institutional Investor, Martin Fridson, chief investment officer at Lehman Livian Fridson Advisors, explained that MLPs should be viewed differently than other alternative asset classes because they are more focused on long-term income with significant yields, instead of quarterly performance.

Tax advantaged status
Another key aspect for investors to keep in mind is that approximately 80 percent of MLP distributions are classified as return of capital, while only 20 percent is standard income. Therefore, while investors are taxed on that 20 percent of income, the return of capital is tax-deferred until they sell the stock. This advantage is due to the fact that midstream MLPs are structured as C-Corps that pay corporate taxes on distributions before income is passed down to investors, representing a prime opportunity for long-term investment.

Bottom line
In the current low price, low rate environment, investors can invest in blue-chip MLPs in the midstream sector and wait for their distributions to materialize as the energy sector rebounds. With limited exposure to price volatility and demand expected to grow, midstream MLPs are less vulnerable to cuts in production. According to an interview with Kiplinger, David Chiaro, portfolio manager with Eagle Global Advisors, only upstream (production) and downstream (sales) MLPs will have their cash flow directly affected by low prices and production cuts.

“The further you get from the wellhead, the less risk you have of volume and price declines,” Chiaro explained.

There is growing concern among investors following the MLP sector that today’s low energy prices are indicative of a much larger trend. Depending on the interpretation of the market, investors either view the MLP sector as the best of times or the worst of times due to recent volatility. However, despite collapses in crude oil and natural gas prices, the fundamental of MLPs are not nearly what the market has indicated in recent months.

Market volatility creates a buyer’s market
Many investors think energy prices have much further to go before they hit bottom. With oil prices falling 44 percent and natural gas prices dropping 37 percent since June 2014, several valuations for MLPs have crashed with it. This has scared many investors out of the sector, but according to Jerry Swank, managing partner, founder and portfolio manager of Cushing Asset Management, the market has hit bottom and now is the time investors should make their way back in.

“Today we are nervous, but we would say we have seen the bottom,” Swank explained. “The fundamentals are not nearly what the market has been telling us in the last few weeks.”

Swank noted that plus fundamentals and a bear market make MLPs a premium investment right now.

Yield plays in the MLP sector
As of June 30, midstream MLP yields were listed at 6.4 percent, compared to 2.4 percent for 10-year Treasuries and 4 percent for utilities and real estate investment trusts. A primary example of midstream success recently was Cushing’s MainStay funds that produced 12-month yields at 13.8 percent for upstream funds, 7 percent for midstream funds and 2.7 percent for downstream funds. However, Swank emphasized that although upstream MLPs have the potential for high yields and distributions, they are exposed to more price volatility because they track exploration and production companies. Midstream MLPs, on the other hand, track transportation and storage companies, which has enabled them to maintain their yields and distributions over time.

Investors favor midstream MLPs
The fallen prices of MLPs in the midstream sector have produced market irrationality. With Q2 earnings in line with expectations going into 2015, energy experts are confused over the pessimism of midstream MLPs on Wall Street. Swank noted that as new pipeline and transportation projects continue to grow with more cap-ex invested into the sector, the midstream MLP market is performing as expected.

“These are great stocks that are down 30%, and there’s been no change [in how they do business],” Swank commented. “They continue to stage IPOs, for instance, and do mergers and acquisitions.”

Therefore, with fundamentals intact and distribution growth expected for the next three years, current market valuations for strong MLPs are coming at discounted prices. Midstream MLPs in particular should bounce back as they have done in the past because demand for oil and natural gas are persistent enough that prices will stabilize and begin to rise. So while there is limited short-term volatility in the sector, midstream MLPs have a long-term horizon with significant upside.

The main reason some investors prefer MLPs as alternative investments is their stable and generous cash distributions. However, MLP unitholders need to put in extra work with their accountant to ensure that the additional income from MLPs remains tax-friendly each quarter. Due to the fact that income from MLPs is filed with Schedule K-1 tax forms as well as standard income tax returns, investors can be turned off by the additional paperwork at tax time. Although, the focus of these investors should not be on the complexities of tax returns, which an accountant can easily handle for unitholders, it should be targeting the right MLPs to invest in. This proves more tricky as many investors use traditional metrics to evaluate MLPs, which are simply inapplicable to this type of alternative investment.

Investors are using the wrong metric
Investors are leery about MLPs because they evaluate the investment opportunity using the debt-to-equity ratio. This metric is used primarily for traditional asset classes because it measures a company’s financial leverage by dividing total liabilities by shareholder equity. However, this metric does not adequately apply to MLPs because of how they operate and fund their companies.

MLPs raise fresh capital from debt markets for funding new projects, so by the very nature of their business model, they incur debt. This can be misleading for newcomers to the MLP space because they may think the companies operate deeply in debt.

For example, Emerge Energy Services’ debt-to-equity ratio has risen in the last 12 months from 0.89 to 1.82 times, but the company has no plans to slow down capital spending on new projects to repay debt obligations. The reason for the company’s comfort with its debt level is that MLPs evaluate themselves with the debt-to-EBITDA ratio. This is the primary ratio for MLPs because while book equity is flat or down nearly every quarter, distributions exceed their earnings. Therefore, unless MLPs issue new equity, their book equity account will remain flat or down, meaning that the debt-to-equity ratio is not applicable because debts will appear high while equity is stagnant.

MLPs pay out all earnings as distributions. So for investors to look to the debt-to-equity ratio in evaluating an MLP’s value proposition, it may appear worse than it actually performs.

Why investors should focus on the debt-to-EBITDA ratio
MLP investors should focus on the debt-to-EBITDA ratio because the companies themselves use it to evaluate the profitability of their projects. For instance, if a project has a one-year or two-year payback, it makes for a valuable investment. The same applies for investors because it presents an opportunity to buy low on a company that will bring massive oil and natural gas supply to a market in demand for it. Particularly in the midstream sector where pipelines and storage operations function on fee-based contracts, meaning they will continue to accrue distributions even in down markets.

Although the debt-to-EBITDA metric is paramount for MLPs because it measures their debt against underlying cash flow, it serves as a better measurement of how growth projects can be viewed. For instance, an MLP is content with letting its debt ratio go a little higher in order to fund a project with a quick payback, which will inevitably bring the ratio back down to its target range. In turn, organic projects with strong and quick paybacks will lower debt-to-EBITDA ratios for MLPs over the long-term.

Ultimately, investors will need to take the debt-to-EBITDA into context for finding the right MLP to buy, because it is a more accurate indicator of value than the debt-to-equity ratio. But finding the right MLP is the most important focus because while some MLPs with less long-term cash flow security prefer lower ratios, others that operate with long-term fee-based toll contracts are comfortable with higher ratios. Therefore, an investor needs to evaluate the security of a company’s cash flow before determining if its leverage is too high.

Bottom line for MLP investors
Many investors pass up MLPs because the value is not clear. However, with the right metrics, MLPs represent a premium long-term investment opportunity, particularly with the current low rate environment, fallen oil and gas share prices and double-digit yields.